Collusion in local public works

A hierarchical model of collusion in local public works is presented. A local authority plans to undertake a project, delegating its construction to a construction firm. Both of them know the project's cost. However, the federal government decides whether to subsidize the project without knowing its cost. Therefore, the local authority and the constructor may agree to misreport their private information, in order to benefit from the allocation of federal grants. We show that different collusive behaviors may emerge. Then, we characterize the optimal federal grant policy. Finally, we investigate when constructing (shutting down) useless (valuable) projects is optimal.